Cover Page

Contents

Cover

Endorsement

Series

Title Page

Copyright

Dedication

Introduction

Acknowledgments

Chapter 1: The Small-Cap Advantage

TWO SOURCES OF OUTPERFORMANCE

SMALL-CAP DEFINITIONS

THE OUTPERFORMANCE OF SMALL-CAP STOCKS

OUTPERFORMANCE WITHIN THE SMALL-CAP SPACE

Chapter 2: Small-Cap Disadvantages

RESEARCH

TRADING

THE SMALL-CAP GRAVEYARD AND REVERSE SURVIVORSHIP BIAS

CAPPING ASSETS

Chapter 3: Small-Cap Investment Philosophy and Process

INSTITUTIONAL APPROACH

PASSIVE AND ENHANCED INDEXING IN SMALL-CAP STOCKS

ACTIVE MANAGEMENT IN SMALL-CAP STOCKS

Chapter 4: Small-Cap Manager Organization

CREATING VALUE FOR THE MANAGER

LAUNCHING A SMALL-CAP FIRM

INVESTMENT TEAM

Chapter 5: The Fund-Raising Process

GENERAL MARKETING STRATEGY

INSTITUTIONAL CLIENTS

FOUNDATIONS AND ENDOWMENTS

CONSULTING FIRMS

PENSION PLANS

HIGH-NET-WORTH INDIVIDUALS

WRAP FEE AND OTHER SUBADVISORY RELATIONSHIPS

DATABASES

THIRD-PARTY MARKETERS

THE CHICKEN-AND-EGG PROBLEM

Chapter 6: Fees, Agency Issues, and Other Performance Drags

COMMON PERFORMANCE DRAGS

FRICTIONAL COSTS IN SMALL CAPS

INSTITUTION-MANAGER AGENCY ISSUES

AGENCY ISSUES IN TRADING

BENCHMARK TYRANNY

COMMINGLED AND SEPARATE ACCOUNTS

Chapter 7: Small-Cap Managers and the Endowment Model

THE ENDOWMENT-MODEL APPROACH TO SMALL CAPS

FINDING AN EDGE

FUNDING SMALLER MANAGERS

FUNDING EMERGING MANAGERS

FINDING EMERGING MANAGERS

Chapter 8: Evaluating Small-Cap Managers

INSTITUTIONAL DUE DILIGENCE TEAMS

ASSESSING MANAGER RISK

ASSESSING INVESTMENT PHILOSOPHY

ANALYZING A MANAGER’S PROCESS

EVALUATING FIRM PRINCIPALS

ASSESSING MANAGER OPERATIONS

CONTRIBUTIONS AND WITHDRAWALS

Final Thoughts

Notes

About the Author

Index

Additional Praise for The Small-Cap Advantage

“Small-cap investing presents unique opportunities as well as unique challenges. Brian Bares masterfully details both in language that is accessible and actionable for investment novices and pros alike.”

—John Heins, Co-Editor, Value Investor Insight
President, Value Investor Media, Inc.

“Brian Bares is a very talented small-cap stock investor, so it is no surprise that The Small-Cap Advantage is a very worthwhile read. In the ongoing search for investment added value, investment managers are smart to heed the small-cap stock market and Brian’s thoughtful perspectives on investing in these securities.”

—Bruce Zimmerman, CEO and CIO, University of Texas Investment
Management Company

The Small-Cap Advantage is a must read for anyone intent on generating superior investment returns in an area of the market that frequently flies below the radar of large investment funds. Brian Bares takes the reader through all the issues a professional investor focused on small caps is likely to encounter, dispensing invaluable data and advice in the process. I can’t imagine anyone better to write this much-needed volume than Brian Bares, one of the most highly regarded small-cap ‘super-investors’ of his generation.”

—John Mihaljevic, CFA, Managing Editor, The Manual of Ideas

Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding.

The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more.

For a list of available titles, please visit our Web site at www.WileyFinance.com.

Title Page

For my parents, Harold and Jane Bares

Introduction

Small-cap stocks can provide investors with high relative returns over long time periods. The asset class has provided a return premium over mid-cap and large-cap stocks since the advent of reliable return data. Despite providing superior returns, small-cap stocks present certain challenges for professional investors. These challenges make prospecting in small-cap stocks more difficult, but they also allow investors who properly structure their strategy and limit their capital base an opportunity to experience outsize rewards. Most professional small-cap managers who post market-beating performance begin to experience an influx of capital. This expansion forces the manager to adjust by trading smaller companies for larger ones or by increasing the number of portfolio positions. Both of these activities, moving up the market-cap spectrum or increasing diversification, tend to diminish the historical advantage afforded to those who prospect in small-cap stocks. The trends pulling professional investors away from small caps help to illustrate why an unusual opportunity exists in the space. Most professional investors who have been successful have graduated into mid and large caps, while the unsuccessful ones have often lost their clients and left the business. What remains is a dynamic opportunity set filled with relatively inexperienced participants. In this environment, classic market inefficiencies are present. Opportunistic investors who limit their capital base and diligently work to understand and exploit these inefficiencies have a legitimate opportunity to post sustained market-beating returns.

This book is meant for aspiring professionals who wish to undertake the treasure hunt in small caps on behalf of institutional clients. It is also written for institutional investors who are looking to hire specialist small-cap managers. Consultants, endowment-model investors, and other institutions must understand the unique challenges and opportunities that separate small-cap managers from their peers in mid and large caps. These investors must have insight into the motivations, strategies, philosophies, and processes of small-cap managers in order to handicap their potential to post market-beating returns. They must also be aware of the pitfalls and traps that cause small-cap managers to underperform.

The part-time investment hobbyist who takes more than a passing interest in small-cap stocks may glean some valuable insight from this book. Serious investment hobbyists who do their own research and manage their own investment portfolios tend to gravitate toward smaller companies for many of the reasons that I articulate in this book. I have a certain reverence for these individuals. I was one of them in my formative years. My fascination with business and my passion for common stock analysis naturally pulled me in the direction of my present career as an institutional manager of small-company common stocks. My intent is to provide practical insight for professionals, aspiring professionals, and the institutions that would hire them, but my technical discussions of the industry, firm structure, investment philosophy, and process should be easily understandable by part-time investment hobbyists. The information in this book should improve their understanding of how institutional small-cap investing can evolve from a passionate hobby into a rewarding career.

Throughout the book, I refer to “investment managers.” These professionals and aspiring professionals come in many different forms and organize themselves in a variety of ways. The assumption I am making when referring to these managers is that they actually make buy and sell decisions for portfolios of small-cap stocks. There is a distinction between pools of investment capital and the people making investment decisions for them. The most common example familiar to investors is the long-only, open-ended mutual fund. The fund itself is a separate entity with a (supposedly) independent board of directors tasked with overseeing the administration and investment implementation of the fund’s strategy. The fund hires a Registered Investment Advisor (RIA), so titled as a result of the firm’s registration with either their home state or the U.S. Securities and Exchange Commission. This entity usually makes the portfolio-level investment decisions. The management of hedge funds is another example of the separation between the manager and the managed pool of assets. The latter is often organized as a limited partnership or limited liability company, and it is usually overseen by a separate legal entity. Many jurisdictions now mandate that the fund’s manager also register with the SEC. The hedge fund management company usually makes the portfolio-level decisions. Despite these nuanced legal and regulatory distinctions, I interchangeably refer to investment managers, hedge funds, mutual funds, portfolio managers, or other similar phrases throughout this book, and I make no distinction between the people and the firms or pools of capital for which they make investment decisions. My intent is to always be referencing those portfolio decision makers who are analyzing small-cap stocks and making buy or sell decisions in an investment portfolio.

The institutional clients sought by small-cap managers come in countless forms as well. Pension funds, sovereign entities, foundations, endowments, high-net-worth family offices, and other firms managing hundreds of millions or billions of dollars must have extensive expertise in structuring a portfolio. These institutional investors typically rely on many outside managers chosen either by an in-house investment staff or by third-party investment consultants. Investment manager due diligence is performed to ensure that an institution will expose itself to the correct investment strategy and in correct proportion to the other pieces of their overall portfolio. The due diligence process is also designed to ensure that a manager’s investment philosophy, process, and operations are robust and reliable. My references to institutions, endowment-model investors, or simply “clients” can be assumed to encompass all of the aforementioned entities who employ specialist investment managers with the goal of increasing diversification and return through niche strategies.

Hobbyists or aspiring professionals may not be familiar with the structure of niche investment management firms, the fund-raising process, due diligence, or the nuances of the institution-manager relationship, but that does not put them at a disadvantage in their pursuit of market-beating returns through the exploitation of market inefficiency. Small-cap stocks are researched using publicly available information. Companies are open to site visits by investors of all stripes, and management conversation is, in my experience, similar for professionals and hobbyists alike. The advantage of experience that professionals possess can be partially offset by the limited capital base enjoyed by hobbyists or aspiring professionals. Given the illiquidity endemic in small-cap stocks, a limited capital base is an important advantage that I examine later in this book in more detail.

As a fiduciary, I must emphasize that a portfolio consisting exclusively of small-cap stocks is not suitable for most investors, institutional or otherwise. Proper diversification at the overall portfolio level is critical. I bring this up primarily for the benefit of those hobbyists and aspiring professionals who may be seduced into overallocating their personal portfolios to small-cap stocks, especially after experiencing some success with exploiting market inefficiency. Others have written extensively on suitability and portfolio diversification, and it is a bedrock teaching of most investment courses. I do not address it any further in this book except in the context of sizing a small-cap allocation for institutional investors; nevertheless, I discuss the benefits of using specialist small-cap managers who invest in concentrated portfolios and the problems that excessive diversification can create for an institution.

My hope is that upon completion of this book, an existing or aspiring small-cap manager has a good feel for what is involved in successfully managing a portfolio for institutional clients, both from a process and philosophy standpoint and from an operational perspective. This book should also help institutions better understand the determinants of success and failure for small-cap managers, enabling them to identify and engage with managers that meet their internal criteria.

This book is by no means a comprehensive review of every available small-cap style or strategy. I leave many of those that I find incomprehensible or intellectually inconsistent out of this book. I concede that some styles and strategies may be very successful in small-cap stocks for reasons that I do not fully understand (particularly in the highly secretive, high-volume, black box quantitative hedge funds).

Each manager develops certain strategy biases and preferences over the course of an investing career. I am no exception. My particular biases manifest themselves in this book, with truncated or omitted explanations of strategies that I deem overly complex and impractical for most managers to implement. It is also difficult for me as a fundamental investor to be evenhanded when describing the merits of technical analysis; as such, I refrain from giving technical analysis anything more than a fleeting introduction, preferring instead to devote attention to fundamental analysis. Ownership of common stock represents an interest in an underlying business, and long-term increases or decreases in stock price reflect changes in business value. Fundamental analysis is an attempt to understand the drivers of business value. This rational approach to analysis is shared by most foundations, endowments, and other institutional investors, and it is the reason that I give it disproportionate attention in this book.

In my many meetings with institutional due diligence teams, I have witnessed their preference for fundamental managers who share certain characteristics. My intent is to identify and describe these for the benefit of aspiring managers who are keen on attracting an institutional client base. Through my experiences as an aspiring small-cap manager, I have wrestled with many of the unique challenges that have the potential to reduce investor performance. My intent is to identify and describe these for the benefit of institutions that seek to optimally exploit the excess returns available in small caps.

The first chapter of this book explores the various definitions the industry assigns to small cap. Small-company return data are then introduced that validate the outperformance of the asset class. The next section examines the substantial opportunity to outperform within small caps as a result of the information opacity that confronts investors. Chapter 2 parses the disadvantages of small-cap investing, how investors can mitigate the effects of illiquidity, and other problems that may surface once a manager’s capital base increases. Various approaches to investment philosophy and process are introduced in Chapter 3. Chapter 4 touches on the organizational aspects of institutional small-cap managers. Institutional marketing and fund-raising are addressed in Chapter 5, and common drags on performance are examined in Chapter 6. The last two chapters summarize key points for institutions to keep in mind as they contemplate funding small-cap managers.

Acknowledgments

This book draws on my experiences in small-cap investing: first as an amateur investor, then as an aspiring professional, and now as an institutional small-cap manager. My path was unusual. Absent from my professional history is a stint at a large money management company or extensive experience with brand-name Wall Street firms. I was able to break into institutional investment management for two reasons. First, I structured our firm to avoid competition from larger players and to take advantage of the unique opportunities that the market offers to investors who limit their capital base. Strategies like the ones run by our firm—concentrated portfolios of small companies—do not offer enough profit potential for most large firms. Second, and more important, I was fortunate enough to have the help and confidence of talented and supportive individuals along the way.

I would like to first acknowledge the manifold contributions of my partner at Bares Capital Management, Inc. The operational scaffolding that created our firm was Jim Bradshaw’s initial contribution. He has also added needed discipline to our investment process. His hand is always steady at the tiller, and I am grateful for his trust, hard work, and loyalty. Graeme Rein also deserves credit for overhauling and improving our research process. He has an encyclopedic knowledge of small companies and a pitch-perfect ear for exceptional investment ideas. His contributions to our success cannot be overstated. Todd Povondra’s work in trading and portfolio accounting has added significant direct and indirect value to our investment process. His work, day in and day out, is often behind the scenes, but he is deserving of public accolades. Clayton Ripley’s energetic pursuit of information on small companies and his feedback on the endowment model have helped shape the future of our company. I am grateful for his hard work and dedication. Ralph Waldo Emerson said that an institution is the lengthened shadow of one man. For Bares Capital, the shadow cast represents a team effort. I cannot thank these individuals enough for always prioritizing our clients’ interests first, the firm’s interest second, and their own self-interest last. In our industry, too many people reverse this order.

I would also like to thank Maury McCoy for his marketing work and expertise. His feedback on our periodic investor letters (and this book) has also been a huge help. Our focus on the foundation and endowment space, and our understanding of the endowment model itself, is largely the result of his hard work and dedication. It takes a clever marketing mind to promote a firm without a track record or a material level of assets under management, but he managed to scale our little firm into something significant.

My deepest appreciation goes out to my old boss and mentor, Mark Coffelt. He took a chance on a young, energetic 23-year-old with no industry experience. Everyone needs a start, and Mark gave me mine. I hope to pay it forward. A tip of the hat also goes to fellow Austin industry insider Sandy Leeds at the McCombs School of Business at the University of Texas for his constant feedback on investment issues and his sourcing of interns for our company. The quality of students we get from Sandy is reflective of his refreshingly high standards in the classroom.

I would also like to acknowledge my editors at John Wiley & Sons for getting this project off the ground. Laura Walsh and Judy Howarth, you were supportive, understanding, and accommodating. What more could an author ask for? The direct expectations I received from you were not coupled with constant requests or demands. Thanks for your confidence. As a first-time author, I had complete intellectual freedom in writing this book, which means that the errors and inaccuracies herein are exclusively my responsibility.

Jennifer Weber at Russell Investments also deserves my thanks, as she was kind enough to grant me permission to use Russell’s data in this book. Likewise, I appreciate that Jackson Wang at MSCI Barra supplied me with historical data on their small-cap index.

I feel a special loyalty to my early individual clients. Without their trust and confidence, I could not have toiled away in obscurity in the spare bedroom of my condo, the floor littered with annual reports, working to build a successful investment management company. I am eternally grateful for their support.

The first few foundation and endowment investors that gave us institutional funding also have my sincerest appreciation. You know who you are. I owe you a debt of gratitude that I could never repay. Taking an unconventional chance on an unfamiliar team of people in Austin without the scale or reputation of our Wall Street competitors is precisely why you have received unconventional results. Indeed, taking that chance is a major theme of this book. It takes independent thinking to invest unconventionally, and the commitment of capital to nascent firms can feel risky at times. Our reciprocation for your confidence is an enduring promise that our continued efforts on your behalf will be our best.

My brothers, Bill and Bryce, deserve my thanks for their constant support. They have always raised the bar for success in my life, and it usually came at times when I needed a little push. I trace my passion for business back to our childhood games of Acquire and Stocks and Bonds (3M, why did you discontinue your great bookshelf game series?). Some inspiration for this book also came from my uncle Kirk and the release of his first novel. I thank him for putting his art out there and hope to see more.

I got lucky in life, having been born to wonderful parents. My father deserves credit for instilling in me a contrarian instinct. His nose for value is matched only by his business sense and work ethic. His curiosity in the natural sciences was infectious, and it helped us prioritize education in our household. He also reinforced in my mind the notion that common stocks should be understood as long-term ownership in an underlying business. His conservative advice to me when I went to open my first brokerage account in my teens—always get the physical stock certificates from your broker—reflects this belief. Even though I now hold my stocks in street-name accounts with various banks and broker-dealers rather than in certificate form, I never forget that they represent fractional interests in companies. He also taught through example that success in business takes focus and sometimes tenacious action. My mother supplemented and sometimes counterbalanced his life lessons with unconditional love and empathy. She lives with high ethical standards for herself and instilled in her children an expectation to live up to similarly high standards. It took me far too long in my life to recognize her quiet genius and wisdom. She got shortchanged in life by having all boys (and grandsons … for now), but her acceptance of and enthusiasm for the guys in her life has so far masked any lurking disappointment. We love her all the more for this.

Thanks to my wife and kids for putting up with me during this project. Ashley, you have won my undying respect for going through pregnancy and managing an energetic two-year-old while I snuck off to the computer for hours of writing. I love you. And little Truman, I’m sorry that Dad did not write a book about bulldozers and excavators. And a full-color pop-up book about small-cap stocks would not have gotten past the editors either, so you are going to have to live with The Small-Cap Advantage in its vapid form. My hope is that one day you can read this and better understand what your old man did for a living. Wilson, completion of this book should roughly coincide with your birth. Your mom and I are so excited to be a part of your life. You and your brother are the best small investments of my life.

BRIAN T. BARES
March 2010